Dear Carrie, I've recently read that it might be better to rebalance my portfolio when the percentages get too far "out of whack" rather than on an annual basis. What do you think?

Dear Reader, Portfolio rebalancing is a core concept for every serious investor, so thanks for asking this question. In a rising market, it's human nature to want to ride it up to see how far it will go, but this is exactly the time when we should be looking at our overall investments and making sure we're not taking on too much risk.

Traditionally, investors have been encouraged to rebalance their portfolios annually. However, what you've probably been reading about is the idea of rebalancing using what's called "tolerance bands." It's an alternate approach that involves rebalancing according to allocation parameters rather than a timetable.

But before we get into how and when to rebalance, I'd like to go over the basics of rebalancing for the benefit of all of our readers.

Why rebalancing is important

Rebalancing means adjusting your portfolio periodically to keep it in line with your chosen asset allocation and risk level -- in other words, maintaining the relative percentages of stocks, bonds, cash and other investments that you originally selected. Often market movements, whether up or down, can push you out of these percentages. As an example, let's say you're a moderate investor with 60 percent in stocks, 35 percent in bonds and 5 percent in cash investments. The stock market has been on a tear and now your stock allocation is at 80 percent, exposing you to a much higher level of risk.

While your first inclination in a rising stock market may be to hang on in the hopes that things will continue to go up, that's probably not the wisest move. Smart rebalancing would suggest that you sell some of your high performing stocks and buy more bonds, bringing your portfolio back to your original percentages.

In this situation you have a couple of choices. First, you can sell asset classes that have performed well and use that money to buy asset classes that have done poorly. It's counterintuitive, but think of it this way: you're not only taking profits, you're actually buying low and selling high -- an investing ideal. Alternatively, if you're adding money to your portfolio, you can direct those funds to the categories that have recently underperformed -- ratcheting up their percentages.

The benefits of rebalancing annually

Rebalancing annually gives you a structure and provides a discipline. It keeps you from overreacting to market movements, which might lead you to sell low and buy high. On the flipside, it can help protect you from what's probably equally common -- doing nothing.

The recommendation to rebalance at least annually gives you a timetable and a plan to help assure that you won't let emotions -- or inertia -- overly affect your investment decisions. Your annual rebalance is also a good time to revisit your goals and attitude toward risk and make changes based on those as well as market movements.

As an added benefit, rebalancing according to a timetable helps you better control trade commissions by limiting your sales. It's also a good opportunity to consider tax consequences -- matching gains and losses in taxable accounts and using tax-advantaged accounts to rebalance to the extent you can. Importantly, if you're in retirement and using your portfolio to generate cash, you can take needed cash for the next year from over-weighted assets first. Conversely, if you're still saving for retirement, you can always add new money to under-weighted asset classes.

The plus side of rebalancing using tolerance bands

Rather than setting a timetable, rebalancing using tolerance bands focuses on a preset percentage of change in your asset allocation whether to the plus or the minus. It also looks at the change in individual holdings in your portfolio.

Let's say your stock allocation is set at 60 percent and you set a tolerance band of 10 percent. If the stock portion of your portfolio reached 70 percent, you'd make a sale. But instead of just trimming back your stocks by 10 percent across the board, you'd zero in on the particular category of stocks (for example, small cap domestic or emerging markets) that had outperformed, and sell only those. Likewise, if a particular category dipped to 50 percent, it would trigger a buy.

With this approach, you'd wait to rebalance until the tolerance band was breached, whether that's three months or three years. By doing so, you more accurately react when the market is moving quickly. And you're able to confidently sit tight when it's not. Current research suggests that this rebalancing method has better results in terms of overall returns. The downside is that you have to pay much closer attention to your portfolio, and to the movement of the individual investments in each asset class.

Getting help when you need it

The method you choose will depend on how closely you want to monitor your portfolio. Here's where an advisor can be extremely helpful. Many advisors have access to software that can track investments within tolerance bands and notifies you when your portfolio deviates from your risk tolerance.

But either way -- whether you rebalance annually or using tolerance bands -- don't ignore it. It may not be the most exciting part of investing but it's crucial to your ultimate success.